Quality of Earnings

There are many concerns that financial statements are over or under statement of earnings. Companies may be motivated to increase earnings to meet expectations. Companies may further have incentives to lower reported earnings in a particular period. Furthermore, financial position should be fairly presented, particularly on the creditor’s standpoint.

Cash flows should be examined, as companies have been ambiguous in generating OCF from borrowing activities. The fundamentals of proper financial reporting quality results in a fair presentation of a company’s operations and financial position. Low reporting quality includes following GAAP but selecting alternatives within GAAP that bias or distort results, using loopholes in accounting principles, using unrealistic or inappropriate estimates/assumptions, stretching accounting principles to achieve desired outcome, and engaging in fraudulent financial reporting.

There is something called a fraud triangle to help warn investors being the following: (i) Incentives that can lead to fraudulent activities, (ii) Opportunities to commit fraud, and (iii) rationalizing behavior after “accounting games”.

From personal financial studies, many citations includes and describes the most common accounting warning signs: They include (i) aggressive revenue recognition, (ii) OCF and reported earnings, (iii) growth in revenues don’t sync with economy, receivables, and/or industry, (iv) growth in inventory is out of line with sales growth or days inventory increasing over time, (v) classification of non-operating or nonrecurring income as revenue, and (vi) other off-balance sheet activities.

​And the quality of earnings needs to be looked with a magnifying glass because common practices such as stretching out payables, securitization of receivables, or even financing some payables can distort the accounting numbers.